DeFi: What is it?

‍

Image Source: FreeImages‍

In the last few years, we’ve witnessed the rise of decentralised applications (dApps), which are software running on a network of nodes without any central authority. These dApps utilise blockchain-based tokens to incentivise the network participants and make sure that they act in the best interests of the network. The new trend we are seeing right now is called DeFi: Decentralised Finance. It refers to applications built on top of blockchain technology and utilising protocols like Ethereum or EOS and smart contracts to tokenise financial assets such as stocks, bonds or other kinds of instruments. These applications can be divided into two categories: marketplaces for financial assets (native tokens) and protocols for different types of smart contracts that manage these assets. All this means that DeFi is a combination of several decentralised applications solving various problems within the space.

Why do we need DeFi?

Currently, the majority of our assets are managed by banks or financial institutions. This means that we have little choice when it comes to the services they offer us i.e. high interest rates, long lock-in periods, low credit limits, etc. In order to get a loan, we have to deposit our assets with the bank and get a relatively small amount in return. This system is called fractional reserve banking: banks keep only a fraction of the money deposited with them in cash and lend the rest out. This system has its origins in the 19th century and is still the primary way that banks operate today. One of the biggest problems with this system is that it introduces counterparty risk. This means that if a bank goes bankrupt, you will lose your assets deposited with it. This happened in 2008 when the financial crisis created a domino effect that led to the collapse of many banks and financial institutions. Unfortunately, there are few ways to mitigate this risk today, other than to keep your assets in cash, which is not a very good investment. This is where DeFi comes in. The primary benefit of DeFi is that it allows users to remove the middleman and become their own banks. In other words, they can tokenise their assets, such as stocks or bonds, issue them on a blockchain and create a marketplace where they can be traded without the need of a bank or another financial institution.

What are the benefits of DeFi?

Decentralised finance offers a wide range of benefits when compared to the traditional means of managing assets. Let’s take a look at some of the most important benefits of DeFi. With DeFi, you have complete control over your assets. This means that you are the only person who can withdraw or trade your assets, which is not the case with traditional financial institutions. You don’t need to go through a long and complicated process to get approved for a loan. You can keep your assets in your wallet or a cold wallet and manage them whenever you want. No exchange can ever be hacked and your assets remain safe and secure. You also don’t have to pay any agent or broker as everything is peer-to-peer, which means that you can set your own interest rates and decide how much you want to earn.

Current state of DeFi

Decentralised finance is the next big thing in the crypto space that is set to change how we manage our assets. In order to make this happen, a number of startups are working on various protocols and applications. One of the most popular DeFi protocols is called Dharma, which has $30 million worth of assets tokenised on its platform. Other protocols include Compound (which recently acquired $14 million), Rate3, dYdX and many others. Another type of DeFi applications are marketplaces for financial assets. Currently, the biggest player in this category is Open Finance and its native token OFN. Open Finance has already closed a $15 million funding round led by Andreessen Horowitz, bringing into existence a new marketplace for tokenised securities and will have $5 billion in daily trading volume by 2022. Other applications include Folio Invest, a robo-advisor for crypto assets, and Trill, a platform for investing in crypto hedge funds.

Problems with DeFi today

As with every new technology, there are certain problems that need to be solved. The current issues with DeFi include: The problem with liquidity in DeFi: Since the market is still at an early stage, it has some liquidity issues. Tokenised assets are not as liquid as traditional assets, but they are getting there. The problem with regulation in DeFi: It is still unclear how regulators will treat DeFi protocols and marketplaces. The Securities and Exchange Commission (SEC) recently issued a warning against people investing in unregistered tokenised securities. The problem with custody in DeFi: Like regulators, many crypto exchanges don’t accept tokens issued on DeFi protocols as they want to avoid being put in a position where they are required to comply with the SEC.

Conclusion

Decentralised finance is a new type of finance that removes the middleman from the equation and allows users to manage their assets on a peer-to-peer basis. DeFi protocols and applications have the potential to change how we manage our assets as they remove the need for an intermediary, such as a bank, which introduces counterparty risk. However, there are some issues that DeFi needs to solve before it can become mainstream. The biggest problems are liquidity, regulation and custody. Nevertheless, there are few promising startups that are working on solving these issues and making DeFi a reality.

‍